Banking

Write banking rules that withstand political winds

Leveling the financial-regulatory playing field requires a complete rewrite of U.S. financial-services law, action that would be stoutly and effectively resisted by battalions of well-paid lobbyists.

A politically plausible approach to reducing many of the regulatory hills and raising up the valleys instead uses the body of current law to the greatest extent possible to allow access to taxpayer-backed benefits only to companies that are directly (or indirectly) bound by the rules established to protect taxpayers and the nation more generally.

There is, though, a middle and more practical course. It does four things: applies like-kind rules to like-kind activities; reduces unnecessary barriers to financial services for underserved or at-risk households; creates special-purpose, regulated charters focused solely on equality finance under rules ensuring that regulatory rewards are obtained only upon providing high-value equality services; and designs a new payment system that includes digital currency crafted with equality objectives kept firmly in mind.

So why not just deregulate?

Wholesale deregulation would certainly be popular to a phalanx of powerful financial industry lobbyists. However, industry-focused deregulation without equality-enhancing recalibration would repeat all too many previous incidents in which policymakers rushed to reduce what was described as unnecessary “regulatory burden” on grounds that it increases “American competitiveness.” These ended in disastrous financial-market and even macroeconomic crashes.

We know this going back to the 1920s, when Congress roared into a regulatory rewrite dissolving many of the rules on finance demanded by Theodore Roosevelt and his progressive allies.

We learned this again in the 1980s, when the savings-and-loan crisis was fired up by regulatory relaxations, such as a memorable plan allowing regulators to issue “net-worth certificates” that masqueraded as capital in the name of increased homeownership.

We learned the dangers of carefree deregulation the hard way all over again in 2008. Even as finance trembled in 2007 ahead of the great financial crisis, the Bush administration’s Treasury Department issued a “blueprint” replete with regulatory rollbacks that made big banks, securities firms and private-equity companies very, very happy. There wasn’t time enough to roll back all these rules before the 2008 financial cataclysm eviscerated the industry.

In 2010, Congress reversed course, directing a tough increase in safety-and-soundness regulation. This made banking safer but most of us still poorer.

Even so, bank regulators in the Trump administration were busily deconstructing the 2010 rulebook when, in 2020, crisis struck yet again. The risks of light-touch regulation were all too evident in 2020 not because banks were fragile — they largely weren’t thanks towhat was left of the post-2010 rules — but because the rules applied asymmetrically.

This opened the way for nonbanks to take many of the risks banks were forced to eschew. Highly leveraged hedge funds, investment funds that took over from bank lending and private-debt markets were just a few of the risky sectors that would have crumbled in 2020 had the Fed not backstopped or — less charitably — bailed them out with all of its giant market-rescue facilities.

Nonbank mortgage servicers didn’t fail, but they certainly faltered to such an extent that they lobbied hard for their own Fed rescue backstop. They ultimately didn’t need salvation because another regulator — the Federal Housing Finance Agency — changed its rules to send a lifeline. But the near-death experience of these nonbank mortgage servicers was largely due to their exemption from the kind of capital and liquidity rules that kept bank mortgage servicers humming.

Economic resilience, financial stability and household strength under stress require that the lenders on which consumers and small businesses depend carry on not just at the best of times, but also when borrowers need them most.

In the mid-2010s, online marketplace lending outside regulated banking took off to the point at which the Treasury Department in 2016 issued a report worrying that the fast-growing sector might create systemic risk under stress due to its lack of stable, deposit-based funding.

In 2020, the sector was still too small to pose systemic risk, but many borrowers who had come to rely on it suddenly found themselves without a go-to creditor. Nonbank fintech lenders performed well in 2020 in terms of delivering federally backed small-business loans, but they largely did so thanks to rent-a-bank arrangements in which insured deposits funded loans outside the reach of bank-capital and other safety-and-soundness safeguards.

Although the Fed in 2020 loosened bank stress tests to ensure lending capacity across the business cycle, this regulatory rollback had barely taken effect when the pandemic hit.

As a result, banks had more than enough capital to turn deposit inflows (that is, the money rushing out of investment funds) into an unprecedented surge of loans resulting from federal government and Fed rescue programs, along with demands from companies to draw down outstanding credit lines for added funding in the midst of the crisis. Had banks not been able to make these loans, the federal government would have had to do so directly, or a financial collapse would have followed the coronavirus pandemic’s macroeconomic apocalypse in very short order.fdg

Of course, banks are far from sinless — cross-marketing within bank products put vulnerable consumers at risk at one large bank, and their mortgage, credit card and customer-service records are still far from sterling.

But, unlike nonbanks, banks can and often are punished for their misdeeds — maybe not enough, but at least to a considerable extent not matched for many nonbanks. That’s largely because many nonbanks are able to pick the state regulator that views them most kindly.

Consumers must thus win redress largely through litigation, a tremendous challenge due not just to the cost of taking a big lender to court, but also to the mandatory arbitration clauses included as boilerplate consumer-agreement language that often bar redress via less expensive class-action litigation.

Finally, insured depositories have another unique obligation to low-, moderate- and middle-income families, and to small businesses in their neighborhoods. Congress in 1977 enacted the Community Reinvestment Act, a mandate that banks make loans, invest in community development and otherwise do their best for economic equality in the communities from which they draw deposits.

No such standard applies to nonbanks offering like-kind services even if their funding derives directly or indirectly from FDIC-insured deposits or they rely on government-sponsored enterprises (GSEs) and federal agencies in key product lines.

Excerpted with permission from the publisher, Wiley from Engine of Inequality by Karen Petrou. Copyright ©2021 by John Wiley & Sons, Inc. All rights reserved. This book is available wherever book and eBooks are sold.



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